If there’s one emotion that stands out as playing a major role in people’s investment behavior, it would be regret.
Terrance Odean, Rudd Family Foundation professor of finance at the Haas School of Business at the University of California, Berkeley, has been researching the impact of regret on the way people invest, in particular how regret—and the ways in which people try to manage it—conditions their behavior vis-à-vis the stock market.
His research through the years has shown, he says, that investors “seek to minimize the emotional experience of investing as much as they can,” and this tendency determines the ways in which they buy, hold and sell stock.
Case in point: In a recent study, the findings of which are yet to be released, Odean observed U.S. investors who went out into the market and bought a stock that they had owned in the past, but sold at a certain point in time. The results of the empirical study showed that investors bought a stock they’d owned before only if they made money on it the first time they owned it and only if the stock’s price had gone down since they bought it.
“This is all about regret: You would not want to buy back a stock that you’ve had a bad experience with, and if you sold for a gain but the stock price ended up rising when you sold, you wouldn’t want to own that stock again either, because you’re going to regret selling it,” Odean, (left), says. “But if you can sell for a gain and you can buy it for a better price, that’s when you will buy that stock again.”
It may sound simple, but regret is a huge parameter that most people are not even aware of, and managing regret plays a major part in the emotional side of financial decision-making.
Regret is also a key factor in what Odean calls the “disposition effect.” His research through the years has shown that investors are more disposed toward selling stocks that have made money, while holding onto those that are poor performers. Even though the results of this can be counterintuitive and even detrimental to a stock portfolio, the overriding reason has to do with managing their emotions vis-à-vis the stocks they own, in particular the regret at owning stocks that are poor performers.
“When people hold onto stocks that are losers, they are trying to minimize their regret, because if a person sells at a loss, he or she runs the risk of regretting that they bought that stock in the first place,” Odean says. “If people hold onto their poorly performing stocks, though, they’re doing so because they’re telling themselves that the market will come back, and they’re coping with their regret by convincing themselves that those stocks that are performing badly will turn around.”
Through the years, Odean has authored several papers on stock market behavior and the emotional side of financial decision making, looking at a host of different emotions and human behavioral tendencies and the way in which they condition investment patterns. (Some findings from Odean’s work were referenced in a New York Times Magazine article by Nobel Prize winner Daniel Kahneman on Oct. 23, 2011.)
Investor overconfidence is an area that he has done significant work in. Working with Brad Barber, the Maurice J. and Marcia G. Gallagher professor of finance at U.C. Davis and the director of the Center for Investor Welfare and Corporate Responsibility, Odean’s research showed that overconfidence—people thinking they know more than they actually do—leads investors to trade more, resulting in unnecessary and costly fees and trading costs.
“One way of thinking about this is that if you’re actively trading stock, and you buy and sell, you would want the stock you buy to outperform the one sold to cover trading costs,” Odean says. “But looking at the performance of stocks that people sold and bought over a year, we found that the stock they bought tended to underperform the ones that they just sold, and in addition, they are paying commissions and spreads. Overconfidence, then, leads to more trading and earning less.”
Men are particularly prone to overconfidence, Odean says, and while both the male and female active traders in his study lost more in the stock market than their buy-and-hold investor peers, men proved to be the greatest underperformers.
Finally, Odean’s research has also shown that human investment behavior is very much conditioned by what people see and hear, by what’s literally in their face all the time. His research has shown that people tend to wait for a stock to catch their attention and then ask themselves if they like that stock or not.
“One day, you’ll hear about 20 stocks on CNBC and that’s when preference comes through,” Odean says.
Owning stocks that are talked about a lot and that are ubiquitous is one of the reasons why asset price bubbles can form, Odean says, because as more people become aware of these stocks, the more they will buy and the more prices will rise, causing others to come in because they believe that prices will go up further.
But owning stocks that everyone is talking about can also create a sense of security, of safety in numbers and wanting to be part of the crowd. And this security is what helps stave off the potential regret at having bought the wrong stock, the regret that all investors suffer from.